Devising a Defensive Theory

First let me say I am not claiming originality here, but let's explore this and see where it goes.

I have been writing since day one about taking defensive action when the market goes below its 200 DMA.

$10,000 bought into the S&P 500, and just held, 25 years ago would today be worth $83,800. If that same $10,000 had gone out when the SPX went below its 200 DMA, and went back in when it went back above the 200 DMA, it would be worth $126,500.

Following this to the letter, the investor would have sold in October and still be out. (My numbers, by the way, are not scientific - I was looking at a Yahoo chart going ten years at a time so the numbers are close but not exact. Anyone wanting to do it exactly and post the result is more than welcome.)

The chart above includes the Swiss franc versus the USD (note it is charted backwards to show the franc going up or down to make the point easier to understand). The chart goes back only as far as Yahoo has currency data. In looking at the two extended periods where SPX went below its 200 DMA (11/2000-3/2003 and 10/2007 through today) the swissi went up 26% and 18% respectively.

So the theory would be stay in SPY while it is above its 200 DMA and swap into the Swiss franc when SPY goes below its 200 DMA. The reality might be a little different.

First, so far all we've done is look in the rear view mirror. I would also note that the dollar rallied against the swissi. So either the world changed between 1998 and 2000 with respect to the dollar and/or the Swiss franc (this is entirely possible), or the last two times were just a coincidence.

The bigger macro item is to explore for the possibility for a better mousetrap. I have unyielding faith in the 200 DMA as an indicator, but taken to the extreme of getting out entirely (not practical but this post is about a theory) and finding a currency likely to go up while out of equities is interesting to ponder. Maybe instead of a currency it should be an absolute return product?

Another problem with the S&P 500 or any broad domestic equity proxy is that there is visibility for the US market to lag other markets for a while (nothing apocalyptic but maybe 5% a year instead of 10%, for example). Perhaps instead of SPY, the long equity exposure should be the iShares All Country World Index ETF (ACWI).

When ACWI is above its 200 DMA then it's all in. When ACWI is below its 200 DMA then it's out of ACWI and into some foreign currency (what about the Sing dollar or the renminbi?) or some sort of absolute return fund?

I find this sort of thing to be fascinating. The point is not "Should I do this?" but rather "How can analyzing a theory like this help my actual portfolio?"

What do you think would be good proxies for the equity exposure and the defensive exposure?

Comments

[AmesTiedeman]

The worst is over for the markets unless some external event happens like we bomb Iran or iraq blows up even worse. We will muddle through I suspect..

[Vancan]

Where is the evidence that this system will continue working? I have a friend who uses a similar system who cannot afford to loose over the long term. I keep asking that question and she cannot answer it.

As a general rule, the future cannot be predicted using only the past as an indicator. Otherwise, some really bright technical analyst would have accumulated all of the worlds assets long ago. The fact that the worlds assets are still spread around tells me that you need something else. Is there some fundamental reason that the author's system will work in future like it has in the past?

[RogerNusbaum]

Vancan, I specifically say "so far all we've done is look in the rear view mirror." This is a theoretical exploration which I also make clear.

[ngwun]

Your hypothetical t/a would have to be exclusively aware, or share. Also innumerable perterbations are introduced by deliberate action, ignorance (ie lack of data) and insanity. And anyone aware of or correctly postulating the actions of said t/a could apply permuted logic to thwart logical outcomes. The spread of assets is a sign of natural entropy. "Power" is applied to elements of the asset set to concentrate them for harvesting.

[RogerNusbaum]

ngwun, i am sorry but i have literally no idea what you are saying, not even an inkling.

[CrossProfit]

Roger,

This is funny, but here is the translation of ngwun's comment.

First, typo; 'perterbations' = 'perturbations'

O.K. here goes, ngwun is saying that there are too many variables that have outside influences or human inputs for your theory to work. Assuming the translation is correct, ngwun thinks that you would need a formula that works more like a thermostat on an air conditioner. On, Off - set to one variable such as temperature. If you try to take into account the calculation of the temperature itself, your theory is too complicated. The 'inputs' that make up the temperature are manipulated (for specific reasons) therefore treating them all equally (like in a basket of stocks) results in the wrong output as in incorrect temperature readings. Something along those lines.

Apparently ngwun is an aerospace engineer.
Hope this helps (don't ask how!).

CrossProfit